But what all fund investors should know is there are ways to limit and even reduce the bite that taxes take out of their fund returns. Here's how:
Know which popular fund strategies result in more taxes
For starters, investors may want to think twice about sexy strategies marketed recently as good plays for volatile markets. Some "long-short" and "go anywhere" strategies, for example, may be good in dealing with the ups and downs of the market, but also may produce more tax obligations than investors like, says Dan Moisand, a certified financial planner in Melbourne, Fla.
The reason: The more actively a fund is managed, the more potential it has to produce short-term gains and thus higher taxes. Gains from securities owned for a year or less are taxed as ordinary income—rates that for most investors are much higher than the new maximum 20% on long-term gains.
Investors also should be aware that for certain popular assets, the tax rates soar past 15% no matter how long the investment is held. Even long-term gains in an exchange-traded fund that owns physical gold, for example, which is classified as a collectible, are taxed at rates of up to 28%. And when funds hold commodities futures, part of the appreciation each year is taxed at ordinary-income rates, which now go as high as 39.6%. On top of that, this year marks the beginning of the health-care law's new 3.8 percentage point surtax on investment income for individuals with adjusted gross income of $200,000, and couples with $250,000.
To see how big a bite taxes will take out of a fund's return, go to Morningstar.com. When you reach the page for a certain fund, click on the tax tab. There you'll see the fund's tax-adjusted returns broken down for various periods. Morningstar also shows how funds rank with their peers in terms of how much of their returns are lost to taxes.
Be strategic about what funds you put into taxable accounts versus tax-sheltered accounts:
Funds that throw off a lot of interest (taxable bond funds, for example) or short-term capital gains (such as funds with active trading strategies) should go into a tax-deferred account, like an IRA or 401(K). Distributions from retirement accounts are taxed as ordinary income, and most investors tend to be in a lower bracket when they retire. But regardless of what bracket you retire in, many advisers recommend deferring paying tax on interest and capital gains for as long as you can, within the law.
Meanwhile, use your taxable account for stock funds whose trades mostly qualify for the long-term gains rate, tax-exempt municipal-bond funds and equity funds that focus on dividends that qualify for the maximum 20% rate.
A fund's prospectus usually will state whether its portfolio is managed with an eye toward holding down taxable distributions. Look also for the "turnover rate," or the percentage of a fund's holdings that change in a 12-month period. Many funds have turnover of around 100%. For a fund to be in a taxable account, the rate should be about 25% or less.
Check actively managed funds for embedded gains or losses
It's like finding money in the laundry. When a fund sells more securities at a loss than a gain, the excess losses can be applied to canceling out taxes in future years. Before 2010, funds could carry losses forward for up to eight years. But following a change in tax law, losses incurred in fund tax years that begin after Dec. 22, 2010, can be carried forward indefinitely.
Since the 2008 market downturn, many funds have been able to keep distributions low by using losses to offset gains. But most funds are likely to have exhausted their loss carry-forwards by now. When funds sell profitable positions now, they likely will have to pay out taxable gains.
Be especially wary of funds that had sizzling performance over the past three years.
"If you buy a fund near the end of a hot streak and a lot of investors bail out, that could force the manager to realize gains to meet redemptions," says Jim Holtzman, who oversees client portfolios at Legend Financial Advisors Inc. in Pittsburgh. Such a fund may have to pay out substantial gains, even though its net asset value is declining.
A fund's annual report should say whether it is carrying unrealized gains or losses. Or click the tax tab on the fund's page at Morningstar.com, which shows how much of a fund's portfolio represents embedded gains or losses.
"If you see a big embedded gain, like 30% or higher, and a fund has high turnover, it's likely to distribute gains in the next couple of years," says Russel Kinnel, director of mutual-fund research at Morningstar.
One fund that still is carrying significant embedded losses is T. Rowe Price Financial Services . According to T. Rowe Price Group, the fund at the end of 2012 had about $143 million in capital-loss carry-forwards and nearly $59 million in unrealized capital gains. So if all its holdings were sold, it would have capital losses equal to nearly 22% of its assets.
Think about harvesting tax losses year-round
Advisers caution against letting taxes alone drive investment decisions. But there can be advantages to harvesting losses when the chance arises, especially if you plan to raise cash later in the year by selling securities at a profit. During a time of sudden market shifts, losses may not stay losses for long.
Use appreciated securities instead of cash for charitable giving
Under tax law, you can avoid taking a big gain in appreciated fund shares by donating the shares to a charity. This is a good way to be both charitable and tax-efficient, says Andrew Altfest, executive vice president at Altfest Personal Wealth Management, New York.
For example, suppose you wanted to donate $10,000 to a charitable foundation. You might consider using fund shares that you originally bought for $5,000, that you have owned for more than a year, and that now have a $5,000 unrealized gain. By giving the shares to the charity, you can deduct the full $10,000 value, and avoid paying capital-gains tax on the appreciation.
Once the donation is completed, you could buy new shares of the same fund at the current, higher price, establishing a higher cost basis and reducing the tax bill on any future sale, Mr. Altfest says.
Consider a fund that tries to limit taxable distributions
Many firms offer "tax-managed" equity funds that aim to minimize taxable distributions. When such funds sell part of a position in a stock, they pick shares that will trigger the lowest tax bill, and they try to match up gains with losses taken elsewhere in the portfolio, says Duncan Richardson, chief equity investment officer at Eaton Vance Management, which has 12 such funds.
Among other firms, Vanguard Group has five tax-managed funds that invest in stocks or stocks and bonds. There are also Dreyfus Tax-Managed Growth and Manning & Napier Tax Managed . USAA Growth and Tax Strategy is a conservative-allocation offering that owns a mix of stocks and tax-exempt bonds.
Keep in mind: index funds and ETFs produce taxable gains, too
Passive funds that are based on broad market indexes can be among the best at avoiding taxable gains distributions. Their portfolios change only infrequently, and primarily because of component changes in the indexes they track.
Vanguard Total Stock Market ETF, VTI +0.97% which owns more than 3,000 U.S. stocks, has a tax-cost ratio of just 0.3% for 10 years, according to Morningstar. Tax-cost ratio is the percentage of a fund's annualized return that is reduced by taxes paid by shareholders on its distributions. The average tax-cost ratio for all funds followed by Morningstar is around 1%, which is another way of saying that an average one percentage point of fund return is lost to taxes each year.
Some passive funds, like small-cap index funds, change more often. As small-cap companies mature, they graduate to other categories and need to be replaced in an index. Vanguard Small Cap ETF VB +0.87% has a five-year tax-cost ratio of about 0.5%.
Choose funds that best fit your tax situation
Tax implications should be of less concern than whether a fund meets your investment objectives. But the funds that you own should be tailored to your specific tax situation.
A taxpayer in one of the two lower federal tax brackets may do better by owning a taxable bond fund than a tax-exempt municipal-bond fund. An investor in a long-term municipal-bond fund would get less than 3% interest. Even after paying tax at 15%, an investor might get nearly 4% from a taxable high-yield bond fund.
"At the end of the day, it's after-tax total return that matters," says Joel Dickson, senior investment strategist and principal in the investment strategy unit of Vanguard Group.
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